Predicting the Likelihood of Hedging by Companies in India - A Logit Model Approach

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The study has analysed the extent and types of derivatives used for hedging, and the factors that explain the likelihood of hedging through derivatives by companies in India. A total of 349 companies were selected and data for the financial year ending 31 March 2018 was considered for the analysis. Using cross-sectional data, the study found that 74% of the companies were hedging through derivatives and forward contract was the instrument widely used to hedge exposures. To identify the factors that explain the likelihood that a company will hedge exposure, the logit model was employed; the dependent variable is binary (‘0’ for non-derivative user and ‘1’ for derivative user). The study identified revenues (log of revenue) and international operations (foreign sales/total sales) as the variables that explain the increase (positive impact) in the likelihood that companies will hedge through derivatives. Quick ratio and size (log of enterprise value) explain the decrease (negative impact) in the likelihood that companies will hedge risks through derivatives. Using the Hosmer and Lemeshow test, the accuracy of the model was predicted. Around 73.9% of the users of derivatives could be predicted as ‘Derivative Users’. The study would be of immense help to investors, as they understand what foreign exchange exposure is and how they are hedged by companies from the disclosures in annual reports. For the analysts, it is about understanding the variables that explain the motives behind companies deciding to hedge using derivatives. Theories such as hedging substitutes, size, and extent of international operations explain the motivation behind the companies’ decision to hedge risks. The study also provides directions for future research.

Keywords: Derivatives, Logit Model, Quick Ratio, Revenues, International Operations, Hosmer and Lemeshow Test

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